Progress in road ahead to depend on policy actions

India is currently facing severe macro headwinds in the form of decelerating industrial growth, widening twin deficits, currency depreciation and sticky inflation. Moreover, heavy dependence on external financing has made India susceptible to global financial turbulence on account of the European debt crisis. FIIs have net sold Indian equities worth $1 billion in Jan-Nov, 2011, against a net purchase of $29 billion in the same period last year. The rupees fall of 18.5% and that of the benchmark stock index of 23.3% during 2011 until December 23 is the highest in the Asian region.

Persistent input-price inflation, increased inflation variability and policy bottlenecks have damaged the investment sentiment and banks have been witnessing a sharp slowdown in the demand for fresh credit sanctions for more than nine months. This has serious implications for Indias potential output trajectory. The only positives at present are the decent performance of agriculture both the kharif and rabi seasons strong FDI inflows and stable NRI remittances.

Given the strong macro headwinds, GDP growth is set to slip to 7.1% in 2011-12. With the weakening of the potential output trajectory, the GDP growth may further weaken to 6.7-6.9% in 2012-13, unless the government takes definite and forceful action to revive investors enthusiasm.

Recently, the global rating agency, Fitch changed the outlook for Indian infrastructure from stable to negative, driven by a range of sector-specific issues and macroeconomic factors. Unless the government addresses critical issues, such as land acquisition, and tackles systemic fuel shortages through prompt and committed action, a major part of the downside risks to growth in 2012-13 may not be arrested.

From the fiscal side, the scope to stimulate the economy by increasing productive expenditures also appears to be quite limited on account of reduced direct and indirect tax collections, difficult prospects for disinvestment and no possibility of any one-off revenue receipts.

In this context, a faster implementation of a comprehensive goods & services tax (GST) expected to improve resource allocation efficiency and better returns to factors of production, would not just help the process of fiscal consolidation but also revive investor sentiment. Not adhering to a predetermined roadmap for GST has significantly reduced the credibility of Indian policy reforms among international investors. As suggested by some noted global thinktanks, the government may like to identify and fast-track 25-30 core infrastructure and industrial projects to revive investment activity in a timely fashion. Such policy actions can revive the inflow of private capital to India and provide more flexibility to the RBI to use its foreign exchange reserves more judiciously.

Other pending reforms that require prompt action from the government to restore investor confidence and improve resource efficiency include pension reform, allowing foreign investment in domestic companies up to 26%, raising the limit on foreign ownership of domestic insurance companies from 26% to 49% and liberalising FDI in domestic airlines.

The Chinese policy response to the global crisis of 2007-08 offers many useful lessons to India. Post the crisis, the stimulus package in China was heavily weighted towards investment (rather than consumption), especially in infrastructure. As a result, it could make a rapid transition to higher growth. India, on the other hand, has been resorting more to consumption stimulus, which has fuelled inflation without improving the supplies of goods and services.

The pressure on the RBI to start reducing the policy rates or relaxing the reserve ratio would again fuel inflation through increased consumption without spurring investment.

Indias economic problems are primarily home grown. One may not see a significant economic revival even after the worst of the global problems get resolved.

Given the conflux of several domestic negatives, one expects only a lukewarm recovery for India during 2012-13.